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Congestion is usually the path of least resistance, but it seems that the reversal pattern the Dow Jones FXCM Dollar was carving out yesterday carried more fundamental pressure than originally expected. On the verge of surrendering to a meaningful retracement after its incredible 3.5 percent rally through the opening weeks of May, dollar traders instead proved far more critical of the currency’s fundamental value. There is little doubt where the greenback found its strength through the close of Tuesday’s New York session as equity markets retreated sharply. Yet, even before the risk aversion move of the latter part of the session, the dollar proved more buoyant than its risk counterparts would imply.

From its own fundamental backdrop, the dollar found strength in the Organization for Economic Co-operation and Development’s (OECD) updated economic forecasts. Against the backdrop of other lowered growth forecasts for other big players, the OECD upgraded its US growth estimates. The group expects growth of 2.4 percent in 2012 (previously 2.0 percent) and 2.6 percent in 2013 (previously 2.5 percent). In the meantime, a $35 billion sale in 2-year Treasury notes drew the highest demand (3.95 bid-to-cover) since November at a sparse 0.30 percent – showing consistent demand despite the supposed excess of US paper on the market.

In the end, the real push behind the dollar’s rally Tuesday (its biggest since March 9) was traditional risk aversion. The pullback from equities, the hit high yield currencies suffered and the renewed burden on the Euro’s shoulders would all bolster the safe haven appeal of the greenback. That said, the S&P 500 has not plunged its own lows and EURUSD is still above 1.2625. When it comes to the risk connection, there was a notable shift from the bounce on Friday and Monday, but we have not definitively ushered in the next leg of market-wide deleveraging. This is a critical component to the dollar’s strength. As a last option liquidity provider, the level of risk aversion needed to keep the reserve currency moving onto new highs is quite high. If we don’t find a quick follow through on risk assets, the dollar could correct to its fundamental mean.

The Euro took a significant, fundamental hit this past session. Through the end of the day, the currency managed modest gains against the high-yield, investment currencies which speaks to the underlying current to the FX market: risk aversion was in play. Despite the uncertainties surrounding the European economy and financial markets, the Euro nevertheless still outperforms the Australian, New Zealand and Canadian dollars in times of true deleveraging. Against everything else though, the euro is a distinct encumbrance to a portfolio. In the morning, the bearish pressure began with the OECD’s downgraded growth outlook (calling for a 0.1 percent contraction in 2012) and warning that policy officials should be ready with more stimulus. That was followed by a downgrade for Spain by Egan Jones and a surge in rates of auctioned 3-month and 6-month Spanish bonds (though the 10-year yield dropped 20 bps and CDS 44 bps). The full press came in the late US session though when former Greek Prime Minister Papademos said his country was at risk of leaving the Eurozone and it could cost €500 billion to €1 trillion. Over-enthusiastic bulls may expect tomorrow’s EU meeting to yield supportive policy (Eurozone bonds?) but don’t hold your breath.

The Japanese yen was under all sorts of pressure Tuesday. A two step downgrade by Fitch to A+ refocuses the market’s attention on the currency’s growing debt load. If that weren’t enough of a sign, the OECD followed up by saying Japan’s debt was heading into ‘uncharted territory’ alongside its 2.0 percent 2012 GDP forecast. The relief in a weakened currency however was sabotaged when risk aversion kicked in later. The BoJ could have taken a swing at trying to drive its currency lower, but deferred by keeping its asset purchases at 40 trillion yen.

British Pound Finds Reprieve from Inflation Slide through Risk Bearing

If risk trends weren’t on the move the past 24 hours, the sterling would have taken a serious hit across the board. Instead, the currency managed to hold its own against the higher yield currencies and slid against the more fundamental balanced and safe haven counterparts. The fundamental hit for the pound came from its April CPI readings. The stimulus conversation is an important one for the currency’s bearings. With a drop in the headline figure to 3.0 percent year-over-year, it is now at the top of its band. Will the minutes show a dovish Posen vote tomorrow?

Tuesday morning, the OECD lowered its growth projections for China to 8.2 percent for 2012 (from 8.5 percent projected previously). For interest rate expectations, the market is pricing in its biggest round of rate cuts for the RBA over the coming year in six months (123 bps). If risk appetite was rising and demand for yields still buoyant, the Aussie dollar may have overcome this pressure; but sentiment trends would do no favors for the currency. With all three drivers aligned for the bears, AUDUSD plunge fresh six month lows.

Though we aggregate the Canadian dollar with the other high-yield commodity currencies, its strength is a little more sound. Though it starts with a lower yield, the Canadian rate is more stable. In fact, it is the only major with a notable outlook for hawkish monetary policy – the market is pricing in 28 bps of hikes over the coming 12 months and a 14 percent probability it’s the next meeting. Up next, we have retail sales data.

Well, that was embarrassing for gold. After struggling to regain its footing at the cusp of tripping below 1525 (and possibly changing the larger trend of the precious metal), the commodity was knocked back before securing 1600. In fact, Tuesday’s 1.5 percent drop was the biggest gold bugs have suffered in two weeks. Where was the fundamental pressure for this particular move? Where general risk aversion may have offered the metal a little bit of a boost, the dollar’s outperformance on the day provide a draw for capital away from the fiat alternative. Should expected (implied) volatility continue its climb, the financial stability implications will further divert capital to the dollar and away from gold.

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